Entry Deterrence

6 Key excerpts on "Entry Deterrence"

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  Industrial Organization

  Markets and Strategies

  • Paul Belleflamme, Martin Peitz(Authors)
  • 2015(Publication Date)
  • Cambridge University Press

    (Publisher)

  In Section 16.3 , we turn to strategies affecting demand variables. Here, we show how brand proliferation, bundling decisions and manipulation of an installed base of customers in the presence of switching costs can be used as Entry Deterrence tools. All these actions may be seen as anticompetitive and are thus subject to antitrust investigations. Finally, we extend the previous analyses in two directions: imperfect information in Section 16.4 and multiple incumbents in Section 16.5 . Regarding the former, we argue that limit pricing can deter entry when the entrant is uncertain about the cost level of the incumbent. As for the latter, we examine whether Entry Deterrence can be achieved, non-cooperatively, by a group of established firms. 56 The terminology is due to Bain (1956). 57 See Schelling’s (1960) analysis of conflicts. 58 For an analysis of industries with endogenous sunk costs, see Sutton (1991). 418 Strategic incumbents and entry 16.1 Taxonomy of entry-related strategies The incumbent’s investment decision in anticipation of the possibility of entry depends on the strategic effect of this investment and on the type of product market competition. To show this dependence, we analyse the following two-stage game between one incumbent firm (indexed by 1) and one potential entrant (indexed by 2). 59 At the first stage, the incumbent chooses the level of some irreversible investment, denoted by K 1 . At the second stage, after observing K 1 , the entrant decides whether or not to enter and then product market decisions are taken. In particular, if the entrant enters, a duopoly results; otherwise, the incumbent remains in a monopoly position. Payoffs are described as follows. If the potential entrant decides to enter, the two firms simultaneously make their second-stage decisions, σ 1 and σ 2 . Typically, this decision is either a price ( σ i = p i ) or a quantity ( σ i = q i ).

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  Economics of Strategy

  • David Besanko, David Dranove, Mark Shanley, Scott Schaefer(Authors)
  • 2014(Publication Date)
  • Wiley

    (Publisher)

  Otherwise, the entrant will pay no attention to the entry-deterring strategy, and it will prove futile. An incumbent may expect to reap additional profits if it can keep out entrants. We now discuss three ways in which it might do so: 1. Limit pricing 2. Predatory pricing 3. Strategic bundling F IGURE 6.2 The Prices That Induce Entry and Exit May Differ Firms will enter the industry as long as the market price exceeds P entry , the minimum level of average total costs. Firms will exit the industry only if price falls below P exit , the minimum level of average variable costs. A verage total cost P entry P exit Marginal cost Average total cost Average variable cost Q Entry-Deterring Strategies • 207 Limit Pricing Limit pricing refers to the practice whereby an incumbent firm charges a low price to discourage new firms from entering. 11 The intuitive idea behind limit pricing is straightforward. The entrant sees the low price and, being a good student of oligopoly theory, assumes that the price will be even lower after entry. If the incumbent sets the limit price low enough, the entrant will conclude that there is no way that postentry profits will cover the sunk costs of entry; it therefore stays out. At the same time, the incumbent believes that it is better to be a monopolist at the limit price than to share the market at a duopoly price. The following example explains the incumbent’s and entrant’s reasoning in more detail. Consider a market that will last two years. Demand in each year is given by P 5 100 2 Q , where P denotes price and Q denotes quantity. Production requires nonre-coverable fixed costs of $800 per year and constant marginal costs of $10. (We ignore discounting.) In the first year, there is a single firm with the technological know-how to compete in this market. We call this firm N. Another firm that we call E has devel-oped the technology to enter the market in year 2. Table 6.1 summarizes useful pric-ing and profit information about this market.

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  Industrial Organization

  Contemporary Theory and Empirical Applications

  • Lynne Pepall, Dan Richards, George Norman(Authors)
  • 2013(Publication Date)
  • Wiley

    (Publisher)

  In this case, predatory Entry Deterrence is possible. We say predatory because the incumbent would not normally choose an initial capacity of K 1 > M 1 except for the fact that this deters all entry, i.e., the action is profitable only because of its entry deterring effect. This is the common definition of market predatory behavior. Practice Problem 12.2 provides a numerical example of this analysis. Formal analysis of the Dixit (1980) model may be found in the Appendix to this chapter. 12.2 Practice Problem Suppose that the inverse demand function is described by P = 120 − (q 1 + q 2 ), where q 1 is the output of the incumbent firm and q 2 is the output of the entrant. Let both the labor cost and capital cost per unit be 30, i.e., w = r = 30. In addition, let each firm have a fixed cost of F 1 = F 2 = 200. (See Figure 12.5 for illustration.) a. Suppose that in stage one the incumbent invests in capacity K 1 . Show that in stage two the incumbent’s best response function is q 1 = 45 − 1 2 q 2 when q 1 ≤ K 1 , and q 1 = 30 − 1 2 q 2 when q 1 > K 1 . b. Show that the entrant’s best response function in stage two is q 2 = 30 − 1 2 q 1 . c. Show that the monopoly or Stackelberg leader’s output is equal to 30. If the incumbent commits to a production capacity of K 1 = 30 show that in stage two the entrant will come in and produce an output equal to 15. Show that in this case firm 2, the entrant, earns a profit equal to $25, whereas the incumbent earns a profit of $250. 298 Anticompetitive Behavior and Antitrust Policy q 2 q 1 L R V B M T 20 15 10 20 30 32 40 N Lʹ Nʹ Rʹ Figure 12.5 An example of Entry Deterrence By initially investing in capacity of 32 in stage one, the incumbent firm insures that it will operate on the response function L  L up to this output level in stage two. It also signals the potential entrant that the incumbent will produce an output of q 1 ≥ 32 in this later stage. The entrant’s best response to this production level is to set q 2 = 14.

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  Economics of Strategy

  • David Dranove, David Besanko, Mark Shanley, Scott Schaefer(Authors)
  • 2015(Publication Date)
  • Wiley

    (Publisher)

  Average total cost P entry P exit Marginal cost Average total cost Average variable cost Q FIGURE 6.2 The Prices That Induce Entry and Exit May Differ Firms will enter the industry as long as the market price exceeds P entry , the minimum level of average total costs. Firms will exit the industry only if price falls below P exit , the minimum level of average vari- able costs. 196 • Chapter 6 • Entry and Exit Entry-Deterring Strategies In the absence of structural entry barriers, incumbents may wish to engage strategically in predatory acts to actively deter entry. In general, entry-deterring strategies are worth considering if two conditions are met: 1. The incumbent earns higher profits as a monopolist than it does as a duopolist. 2. The strategy changes entrants’ expectations about the nature of postentry competition. Oligopoly theory (see Chapter 5) suggests that the first condition is nearly always true. The second condition is necessary because any strategy that the incumbent engages in prior to entry can only be effective if it changes the entrant’s expectations about postentry competition. Otherwise, the entrant will pay no attention to the entry- deterring strategy and it will prove futile. An incumbent may expect to reap additional profits if it can keep out entrants. We now discuss three entry-deterring strategies: 1. Limit pricing 2. Predatory pricing 3. Strategic bundling Limit Pricing Limit pricing refers to the practice whereby an incumbent firm charges a low price to dis- courage new firms from entering. 12 The intuitive idea behind limit pricing is straightfor- ward. The entrant sees the low price and, being a good student of oligopoly theory, assumes that the price will be even lower after entry. If the incumbent sets the limit price low enough, the entrant will conclude that there is no way that postentry profits will cover the sunk costs of entry; it therefore stays out.

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  Competition versus Predation in Aviation Markets

  A Survey of Experience in North America, Europe and Australia

  • Peter Forsyth, Peter Forsyth, David W. Gillen, Otto G. Mayer, Hans-Martin Niemeier(Authors)
  • 2018(Publication Date)
  • Routledge

    (Publisher)

  If airline managers report that these route conditions do prevent entry, this would mean in turn that first of all actual competition does not exist because entry does not occur and consequently the monopoly is sustained. However, as suggested by evidence, actual competition is most relevant to control an incumbent's behaviour. Second, if the monopolist in question is aware of both possessing such an advantage and the advantage's entry deterring effect, potential competition does not exert a threat since the monopolist does not fear entry. Consequently, neither potential nor actual competition restrains the monopolistic incumbent. 5 To render things worse, competition policy does not recommend taking measures, when applying normative definitions of entry barriers. However, before deciding how to deal with this challenge, the evidence needs to be viewed, as this issue may in fact be irrelevant. Despite its potential, this survey-based methodology is relatively new to the field of entry barriers. In cross-sectional studies, Smiley (1988) and Bunch/Smiley (1992) explore, from an intra-firm perspective, how frequently certain strategic Entry Deterrence measures are applied. Investigating the marketing executives' perspective, Karakaya/Stahl (1989) provide empirical evidence on the importance of innocent and strategic entry barriers in consumer and industrial goods markets. Brewer (1996) analyses which industry conditions might prevent potential entrants from a commitment to the British rail freight industry. Although all these studies have made important contributions to the knowledge of entry difficulties, only one of these investigates how industry entry barriers are being perceived by firms whose entry might be prevented. Moreover, none of these studies have concentrated on the airline industry. However, air carriers apply some peculiar measures (e.g. code-sharing, hub-and-spoke system) when serving a market

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  21st Century Economics: A Reference Handbook

  • Rhona C. Free(Author)
  • 2010(Publication Date)
  • SAGE Publications, Inc

    (Publisher)

  Theorists working in the field of predatory pricing express concern that the courts have rarely cited the strate-gic (i.e., post-Chicago) literature, even though this litera-ture offers an array of models where predation is a rational, profit-maximizing strategy. It is important to note that in every strategic model, predation occurs in equilibrium only if recoupment is possible. Of course, recoupment is only possible if there is some barrier to entry, so this line of research could be thought of as the study of strategic entry barriers. The arguments put forth in the strategic entry bar-rier literature are not in conflict with the crux of the Brooke Group ruling. Rather, some economists worry that the courts are inadequately assessing the probability of recoupment. Courts that fail to recognize market imperfec-tions might miss possible ways these imperfections can be exploited to keep rivals out. Critical in McGee's (1958) critique of the Standard Oil case was the assumption that costs were similar across firms. When markets work well and technology is easily transferable, such as in oil refining, this assump-tion is reasonable. But some markets fail to meet these conditions. One example is when production exhibits a learning curve, where costs fall as a producer obtains more experience in production. Cabral and Riordan (1994, 1997) show that a learning curve can be manipu-lated to create a barrier to entry. In such models, a firm preys early to increase output, thereby moving farther down the learning curve and eventually gaining an entry-deterring cost advantage. This behavior clearly meets the predatory pricing standards put forth in Brooke Group. However, the welfare effects of such predation are inde-terminate. As stated in the conclusion of the 1997 paper, The information requirements of fashioning an effec-tive legal rule against harmful predation are formidable (p. 168).

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